Methods of growth
1 Takeovers and mergers compared to organic growth
Takeovers and mergers have the following characteristics:
Quick methods of expansion.
You can take over a ready functioning operation – useful if you are expanding into another country or product line as risk is reduced.
You have to pay for goodwill. This will be reflected in the purchase price but is usually difficult to value.
You can get into a bidding war with another company and end up paying too much
There are disruption costs involved when trying to integrate the two businesses. For example, employees often feel threatened and de-motivated. Different systems have to be brought into line if cost savings are going to be realised.
There is an asymmetry of information: sellers usually knowing more than buyers. His increases the risk to the buyer.
Immediate need for capital either by issuing shares to the target company’s shareholders or an outflow of cash.
The second main approach to growth is known as organic growth. Here the company uses its own resources from retained profits or perhaps by raising additional capital, but grows its business internally. The business that it is growing could be the same as its existing business or could incorporate an element of diversification.
This method has the following characteristics:
Relatively slow.
Popular with employees. If the business is growing, they see job opportunities and job security.
There will be no valuation problems, you are not buying goodwill which could be destroyed later or which may never have existed.
If there is an element of diversification you have to learn as you go along. You are not buying a ready-made company with knowhow, staff, goodwill, and a customer base.
Often there is no need for high initial expenditure.
2 Other methods of growth
We now look at some other methods of growth: joint ventures, licensing, franchises, and strategic alliances.
Joint ventures. In joint ventures, two companies will normally establish a third company, contributing cash, other assets, know-how, and personnel. Joint ventures are extremely good ways of dealing with large projects where high amounts of capital are required, where there is high risk, and where a mix of skills is essential. Joint ventures can spread the burden of providing finance and bearing the risk, and by choosing your joint venture partners carefully, you can accumulate an appropriate mix of skills. It’s important at the outset that all the parties to the joint ventures know exactly what is expected of them, how profits are to be shared, and how exit from the joint venture is to be managed.
Licensing. Under licensing arrangements, one company gives another the right to use a process or a trade name. For example, it’s very common for brewing companies where a company in Belgium licenses a brewery in, for example the UK to make beer. There is relatively little point in making beer in Belgium, putting it into tanks or vats, and shipping it across the sea. Most of what is being shipped is water! However, if you license a company in the UK to make beer, tell them the recipe, allow them to bottle it, and market it, you greatly improve the efficiency of the operation. For the licensor (that’s a company granting the license), this is a relatively low risk way of growth. They earn the money primarily from royalties and don’t have to undertake any great risk in setting up production and distribution facilities overseas.
Franchising. A franchise can be regarded as a more involved type of licensing agreement. Many retail and fast-food organisations operate through franchises. Typically, the franchisee (that’s the person who wants to start the business) buys a franchise from the franchisor. In return the franchisor provides advice and the right to use a process and trade name. The franchisor might also provide raw materials. Certainly, the franchisor will impose very strict rules so that the operation to which they give their name trades in such a way that the organisation is not damaged. The franchisee manages the day-to-day operations of the franchise, buying raw materials from the franchisor and selling them. Often a royalty is paid back to the franchisor based on profit or turnover. Many people are attracted to franchises because they give the impression of running your own business yet with a safety of using an established name. It’s much better if you can hoist the name of, say, McDonald’s over your hamburger shop than simply using your own name. The franchisor can provide know-how, marketing and goodwill, and all of these lower the risk that the franchisee suffers. However, many franchisees find that the rules imposed by the franchisor are more inhibiting than they expected, and they end up with being little more than an employee yet bearing more of the risks.
Strategic alliance. A strategic alliance can be very useful where a more formal merger or takeover is not allowed or is not thought to be wise. An example of strategic alliances is the co-operation which is undertaken by many airlines. They form an alliance, such as ‘Star Alliance’ and this allows their passengers to make use of different airlines and different airlines lounges, more or less seamlessly, and to collect and use their air miles in a common scheme. Such alliances are allowed in airlines where the takeover of one airline by another is often resisted on monopolistic or nationalistic grounds.